Merrill's Board Trouble

As the brokerage giant's stock gets pummeled, outsiders question how the company's board has handled the problems

by Steve Rosenbush

Merrill Lynch (MER) shares were under furious assault on Nov. 2, as the company, which last week forced out its CEO in the wake of huge losses, faced more questions about the scope of its exposure to investment pools that own subprime mortgage debt.

The selling was triggered initially by a story in The Wall Street Journal, which said the company has engaged in deals with hedge funds that "may have been designed" to "delay the day of reckoning" on losses in mortgage-backed securities. The story, citing an unnamed source, said the transactions are "likely" to be examined by the Securities & Exchange Commission.

The story led Merrill to issue a statement: "The story is nonspecific and relies on unidentified sources. We have no reason to believe that any such inappropriate transactions occurred. Such transactions would clearly violate Merrill Lynch policy," the company said. An SEC spokesman declined comment, saying the commission has a policy of not confirming or denying the existence of an investigation.

Merrill Shares Take a Beating

The statement failed to stem the wave of selling of Merrill's stock, which was down as much as 12% on Nov. 2. "The wording of the release doesn't inspire confidence," says Adam Compton, an analyst with RCM Capital Management, which owned 800,000 shares of Merrill as of June.

A downgrade on Nov. 2 from Mike Mayo, a bank analyst at Deutsche Bank (DB), also contributed to the stock's decline. He lowered his rating on Merrill from buy to hold, citing the possibility of more writedowns after the company took charges of $8.4 billion in the third quarter for losses in the credit and leveraged loan markets.

Merrill stock, which was already down 30% for the year, ended down 7.9% for the day, at 57.28. The shares are down 42% from their 52-week high reached in early January, when the company was riding the late stages of the boom in collateralized debt obligations (CDOs), which are investment pools with heavy exposure to mortgage-backed debt. The price of insurance on Merrill bonds has risen, too, suggesting traders believe the company's debt will be downgraded to "junk," according to Tim Backshall, senior credit strategist with Credit Derivatives Research, an investment adviser in Walnut Creek, Calif.

Investor Confidence Shaken

It was also a bad day for other financial companies such as Citigroup (C) (BusinessWeek.com, 11/1/07). Citi's board has called a special board meeting for the weekend of Nov. 3rd, raising questions about the future of CEO Charles Prince (BusinessWeek.com, 11/2/07).

At Merrill, the big worry is exposure to the CDO market (BusinessWeek.com, 10/26/07). Mayo said Merrill reduced its net exposure to $15 billion in the third quarter from $32 billion in the second quarter, but only wrote down $6 billion worth of CDO exposure, "leaving a question as to how it reduced the 'missing' $11 billion." The allegation is that Merrill may have sold some debt to a hedge fund, with an understanding that the hedge fund could later sell the debt back to Merrill at a minimum price. "Trust is an issue…we have increasingly lost confidence in the financials of Merrill," Mayo wrote.